Saturday, August 28, 2010

I have just read Daniel Amman’s excellent biography of Marc Rich - the oil trader notoriously pardoned by Bill Clinton. I don’t want to get into the politics and ethics of the pardon other than to note that few things in it are black-and-white when you finished reading the book.

But the way Marc Rich made his money is fascinating and says a lot about the current re-regulation debate.

Marc Rich exploited price fixing/import/export controls to make simply unbelievable profits trading oil. Marc Rich & Co (the Swiss vehicle) was started with just over $1 million in capital and a couple of years later was making in excess of $200 million in profit. This level of profitability exceeds - by far - any other trading operation I have ever seen - and was probably the most profitable trading operation in history. Marc Rich & Co (since renamed Glencore) is possibly the most valuable business in Switzerland within the lifetime of its founder.

A typical Marc Rich & Co trade involved Iran (under the Shah), Israel, Communist Albania and Fascist Spain. The Shah needed a path to export oil probably produced in excess of OPEC quotas and one which was unaudited and hence could be skimmed to support the Shah’s personal fortune. Israel - a pariah state in the Middle East - wanted oil. Spain had rising oil demand and limited foreign currency but was happy to buy oil (slightly) on the cheap. Spain however did not recognise Israel and hence would not buy oil from Israel - so it needed to be washed through a third country. Albania openly traded with both Israel and Spain. Oh, and there is an old oil pipeline which goes from Iran through Israel to the sea.

So what is the deal? The Shah sells his non-quota oil down the pipeline through Israel and skims his take of the proceeds. Israel skim their take of the oil. Someone doing lading and unlading in Albania gets their take and hence make it - from the Spanish perspective - Albanian, not Israeli oil. The Spanish ask few questions. The margins are mouth-watering - and they all come from giving people what they really want rather than what they say they want. We know what the Shah wanted (folding stuff). We know what Israel wanted (oil). We know what Spain wanted (cheap oil). Who cares that Spain was publicly spouting anti-Israel rhetoric. [Similar trades allowed South Africa to break the anti-Apartheid trade embargoes.]

It also helped that Marc Rich & Co was a (highly) multilingual firm. Rich is fluent in Spanish (it is the language he talks to his children in). He speaks English, German, Yiddish and presumably Hebrew. His business partner (Pincus Green - pardoned the same day as Rich) speaks Farsi amongst many other languages. They could do this deal because they could negotiate it and - deep in their heart they hold the Ayn Rand view that trade is a moral virtue and hence they do not need to be concerned with other morality. [The only line that matters is the law - and then it might not be the law of his adopted country - Switzerland - rather than the United States where he was resident.]

And when the Shah fell? Oh well - Pincus Green - an American Jewish businessman - gets on the plane to Iran and does a similar deal with the Mullahs - who - despite their rhetoric will sell oil down a pipeline through Israel - and will allow Israel to skim their take. Trading through the American embargo - well that is just another instance of getting around restrictions and profiting (very) handsomely. [Rich would argue that the trades were done by the Swiss company which was not subject to the American restrictions.]

The regulatory regime for domestic American oil was also perverse. Old oil (meaning wells drilled before the first oil crisis) received one price. New oil (wells drilled after the crisis) received a higher price. Squeeze oil (oil that was extracted from wells that ran less than 10 barrels per day) received a higher price still. The oil could be chemically identical and the price difference over $20 per barrel. Obviously a trader with a method (any method) of changing the oil source could make a fortune. Again I am not commenting on legality or morality. That was just plain fact. Ayn Rand applies - you give a value and you receive a value.

What all this regulation did was that it allowed people to make simply grotesque profits by thwarting regulation. The regulation thus worked less well and it was socially unfair. Pincus Green was good at negotiating in Farsi. He was astoundingly brave going to Iran immediately after the Shah fell. He was good at organising shipping. He worked really hard - but he did not invent something that changed the world and he wound up a billionaire. Traders make money by intermediating real business solutions - but these were real business solutions to problems made by legislation. Bad regulation, moral indignation about “trading with the enemy” or “trading with Israel” or with racists in South Africa made people with Ayn Rand morals exceedingly wealthy because you could arbitrage your way around any of these regulations.

If you read the Marc Rich book you will understand why lots of people who were generally left-of-center became ardent deregulation advocates. Plenty written by Krugman look like it advocates deregulation. (Not convinced: see his review of Laura Tyson’s book on trade theory in Pop Internationalism. Indeed see most of Pop Internationalism as favorably reviewed by - of all people - the Cato institute.)

Crank forward to the current crisis: what we see are the problems of deregulation and complexity. We see traders and investment bankers who get rich - not as rich as Marc Rich and Pincus Green - but still frighteningly rich. And they get there by taking risks that are ultimately absorbed by taxpayers or mutual fund holders (particularly taxpayers). We see agency problems everywhere - where management enrich themselves at the expense of others - and they do so by capturing upside but (in part) socializing the downside. Regulation in this case is about controlling agency problems - about stopping people privatizing the profit and socializing the losses.

A plea

As a plea then I want a debate about the right form of regulation - a regulation that controls agency problems but does not allow arbitrage opportunities to people with “Ayn Rand morals”.

We are not going to get that from the current Tea Party Republicans. They simply argue that regulation (they say but do not mean all regulation) impinges on “freedom” (something that is clearly a good but hard to define). However many of the same people want planning regulations to ban a mosque in downtown New York because it is an insult to the victims of 9/11 (and banning mosques is not a restriction on “freedom”).

If that is the level of debate we are not going to get good re-regulation - we are just going to get pandering to whichever lobby group manages to garner most support. And that is a real risk because we will leave agency problems in place (they benefit the rich and powerful) and we will introduce the same sort of (dumb) regulation that made Marc Rich and Pincus Green astoundingly wealthy. That sort of regulation also benefits the rich and powerful - especially those with “Ayn Rand morals”. [The rich and powerful - if you have not noticed - are good lobbyists. Unless we are careful many amongst them will get their way.]

I don’t know how to do this well - but I thought I would state the obvious. The most obvious things that need regulation are things with a government guarantee (implicit or explicit). If you have an implicit guarantee (as we now know almost all large financial institutions have) then regulation really matters. If there are large agency problems (small shareholders, large management) then regulation should be deliberately biased to put power in the hands of shareholders not managers (eg banning staggered board elections).

Likewise other agency problems should be strongly policed and the regulation should be of the form that allows that policing. When Elliot Spitzer found that Marsh - a large insurance broker - was participating in bid rigging against schools buying insurance that was shocking - and is precisely the sort of thing in financial markets that should be policed strongly. But it took Elliot considerable effort to find and prove his case. The rules should be established so that sort of behaviour is really difficult to hide.

And I do not think that I need to explain to anyone how much mortgage brokers contributed to the crisis by (a) deliberately misleading borrowers about conditions on their mortgage and (b) participating in the faking of borrowers income/assets/education level when they on-sold the loans to Wall Street. Agency problems were at the core of the crisis.

On the other side if there is no agency problem then deregulation should remain the order of the day. Trade restrictions create arbitrageurs - and the arbitrageurs ensure the trade restrictions don’t work anyway.

There are obviously going to be extensions to this rough rule - and this post is really to garner discussion. But for a start I expect agents who benefit from their agency (and the abuse of their agency) to join the Tea Party.

It is difficult to get policy right. And when and if the policy is got right we are in for a very long fight to implement it.

Rackspace claim 99.99 percent availability - but it did stuff up once and upset Michell Maulkin and Justin Timberlake. That was a small failing (and I would not worry too much about either of those people being upset). But more to the point - the failing was less than 20 minutes.

We however at Bronte have a server (an old Dell box!) connected to the net via a DSL modem and the vagaries of Telstra (possibly the OECDs worst incumbent phone company). My business website is down. Worse - my @brontecapital.com (that is business) emails are bouncing...

The problem is - you guessed it - Telstra.

One advantage of a virtual server in the "cloud" is that it can be mirrored in jurisdictions other than my own and hence removes the Telstra risk. Telstra risk is a serious problem in Australia.

The cloud may be an online offer - but it is almost certainly a superior product. And to anybody whose email bounced... sorry.

Over time we will give up on in-house information technology and move entirely into the clouds.

And if you are a Hewlett Packard shareholder you should think that through. The cloud is ultimately cheaper, allows you to outsource (or remove) your IT staff and offers superior execution. That is wonderful for many - but for the incumbent midrange server maker having a competitor that is superior in every way looks - well - ugly.

Tuesday, August 24, 2010

I have just done a huge amount of work on virtualization (see the recent "geek" posts here and here and here and the post on Dell). I worked out where Dell was going on virtualization and understood that HPQ was likely to play "catch-up". (This surprised me - I was stunned how far Dell had travelled.)

I understood the 3Par acquisition - and knew that HPQ was also lacking in this area and thought that Dell was (cleverly) leaving Hewlett Packard strategically challenged. I also put a small short on HPQ because of this.

Going long 3Par was an easy bet. Its downside was protected by Dell's cash bid (which would completed as the deal was important to Dell and Dell could finance it with cash on balance sheet). The upside was an overbid by HPQ. It was a bet with very nice risk-return characteristics.

And I did not do it.

Politely that is "lack of execution" - but I should stop making excuses. One word for that one: dumb.

Sunday, August 22, 2010

I have already been asked by email what the Australian election result means and what will result from it. At this point I do not know – and frankly nor does anybody else. However I hope – and removing my politics from this – to give a quick handbook for someone with almost no knowledge of Australian politics. So please forgive me starting very basic.

What you need to form government

Australian politics is based on a “Westminister system”. That is – like the UK – to become a national leader you first need to elected a local representative in the “house”. This representation is in single-member seats. To become the national leader (the Prime Minister) you need to control the votes of a majority of the members of the House. Normally this happens through tight “party affiliation”. When you elect a member you know which party they belong to – and so you are really voting – indirectly and by convention – for a Prime Minister.

There are 150 members of the house – so 75 members for both sides would be a tie. You need 76 members under tight control to form a majority government.

A short summary of the political parties

I need this to explain roughly where the political parties sit. The main conservative party in Australia is (strangely) called the Liberals. There is a second conservative party called the Nationals. It is generally impossible for the Liberals to form government without an alliance with the Nationals – and so the conservative parties are generally known as “the Coalition”.

The Nationals are a strange and declining beast. They started life as “the Country Party” and their affiliation was Agrarian Socialist and (highly) socially conservative. The most famous of all Country Party politicians (Black Jack McEwan) was also probably the most economically interventionist politician Australia has ever had. The reason that the Nationals are declining is largely demographic change. Australia is becoming more urbanized as the average size of farms increases and agriculture becomes more of a “scale game”. Secondly the coastal seats are having huge demographic change as Sydney and Melbourne voters are moving to the coast either for lifestyle reasons or retirement. (“Sea change” is a big demographic trend in Australia.)

Like in America, conservative politics is an amalgam of economic conservatives and social conservatives. In America the social conservatives are the dominant voting block within the conservative party. In Australia it is more balanced.

The main non-conservative force is the Labor Party – a party which grew out of the (declining) unions and – is to some extent – still beholden to the unions. In the dim-distant past Labor party officials used to refer to each other as “comrades”. They continued to do it ironically well into the 1980s because it infuriated the right wing members. Now they just call each other friends (which is itself ironic). This is the party of factionalized power and voting blocks. Other than ensuring a remaining power base for union officials it has been difficult for many years to say what the party stands for other than a pragmatic approach to gaining and holding power.

Mostly to the left of the Labor party is the Greens. The Greens are hard-line on environmental issues (mostly), mostly very left-wing on straight economic issues and mostly extremely liberal on social issues. The Green policy summary for this election are (a) not just have an emission trading scheme for carbon but tax the polluters into the bargain, (b) make the miners pay the full-undiscounted original mining tax, and (c) legalize gay marriage.

The classic dividing line between the Greens and the Labor party is logging of high conservation value forests. The Greens are hard-line opposed. The Labor party is (mostly) inclined to take the position of the (unionized) forestry workers. They can irregularly (say once per 20 years) take a power-pragmatic position to align with the Greens in exchange for Green preferences in urban areas.

If you are mostly economically conservative, mostly socially liberal and fairly hard line on environmental issues there is simply no single party to belong to or vote for in that you will disagree with their positioning on something.

The balance elected last night

There are many “seats” (meaning positions in the “house”) that will come within a couple of hundred votes so final results will not be known for a while. However the split is likely to be 73 Coalition, 72 Labor, 4 independents and a Green. Three of the independents started their career with the National Party – so the most likely outcome is that they will support the Coalition on matters of confidence and we will get a Coalition minority government. But that assumes (as I would not) that the independents are a stable block.

The three conservative independents are very different beasts indeed. Firstly Bob Katter – representing an electorate in remote far north Queensland – is an old-fashioned National Party politician – and split from the Nationals over differences on economic policy and social policy. He is more interventionist on economic policy and more conservative on social policy than the Coalition. Indeed his positions are so strong they are almost a caricature of old-fashioned National Party values. The expression – not necessarily unkindly - is that he is as “mad as a Katter”. This advert is representative of the man.

Do look at this video. I cannot imagine any other politician advertising himself as the right guy when there are crocodiles on the loose or cattle have gone astray.

Rob Oakeshott by contrast represents a coastal electorate much closer to Sydney. He is an economic conservative and social liberal. His split with the Nationals is because his socially liberal values did not fit in.

My only involvement with him (or more precisely his office) came about because of Astarra. He represents a coastal electorate with many retirees and some victims and he is the only politician who has taken up the issue. Rob Oakeshott is likely to be friendly with Bob Katter – but on many issues they are a long way apart. I can’t imagine myself ever voting National – but I have to confess to liking Oakeshott a lot of the time – and I suspect I would like the man (though I have never met him).

I do not know anything about Tony Windsor (the third conservative independent) except that his electorate is more mainstream National Party territory – and it is likely the man is closer to the National Party than either of the other two conservative independents.

The Green is – as far as I can tell – a typical Green – he won a safe Labor seat taking extremely socially liberal positions in a socially liberal inner-urban electorate.

The remaining independent victory was a total surprise. He is the only minor Australian politician I would expect any of my non-Australian readers to know. The name is Andrew Wilkie – and I would describe him as a centrist with a white-hot fierce moral integrity that could easily be confused for self-righteousness. He started his career in the military and was educated at Duntroon (the Australian equivalent of West Point). He rose rapidly to Colonel and along the way joined the Liberal Party. He left to be an analyst at ASIO – the Australian equivalent of the CIA. He famously and publicly resigned when he felt the intelligence about Iraqi weapons of mass destruction was being doctored for political reasons. His resignation was global news. He later stood as a Green against the incumbent Prime Minister in the 2004 election. He moved to Tasmania and stood as an independent against the Greens in a Labor stronghold seat and he has probably won.

Summary

I do not know whether a stable alliance can be made of these people – but the Coalition plus three originally conservative independents makes one think the most likely outcome is a Coalition government. However it will be very hard to keep Bob Katter in the tent simply because he is so extreme on so many issues. If the issue-of-the-day however is one where the government is more socially liberal than Katter (ie most people on most issues) then perhaps they can make up the numbers with either Wilkie or the Green.

Saturday, August 21, 2010

I recently posted three long pieces on computing and virtualization. There were two trends that mattered.

(a). Enterprise computing was moving to the cloud - sometimes an external cloud - but more often-than-not an enterprise cloud. Computers would henceforth be virtual machines sitting on some mondo-powerful server and thin clients. This setup was superior for a range of reasons that I went into. But more than superior - it was cheaper to set up and MUCH cheaper to run.

(b). Personal computing was going towards ever-more-powerful handheld devices on which I thought PC as-an-app would be an end game. These devices will plug into screens and keyboards at home if you wanted - and to a large extent they would replace or displace the personal computer.

Microsoft would be a winner if it remained the cloud desktop (which it has at every firm I know who uses an enterprise cloud). It would be a big winner if it also captured a worthwhile place in the handheld device market. I thought that unlikely - but the reviews of new Windows 7 phones are convincing me that a Windows 10 phone could be a big winner.

Although I did not discuss this, one implication was a bleak future for "beige box makers". Computers disappeared into a cloud or into a shiny and extremely well made personal computing device. A logistics firm which assembled beige boxes (as Dell was in its glory days) had no future. You either needed to be in the enterprise server (especially blade server*) market or a consumer good maker. Dell I posited was an extremely poor consumer good maker - as my old XPS1330 laptop would attest. [That laptop had the notorious Nvidia graphics chip problem... Hewlett Packard also dealt with it badly.]

But Dell is approaching the enterprise cloud product in a purposeful and seemingly effective way. Sure mostly they are doing it via acquisitions - see the latest purchase of 3Par. 3Par make integrated hardware-software solutions for storage in enterprise clouds - in other words sophisticated jbods**. And this is after a few other acquisitions in that area.

And surprisingly it is working. Dell server growth was rapid even as their beige-box business continued to falter. As they they stated "storage and server revenue increased 35 percent with rapid growth in blades". They talk about integrated solutions to enterprise cloud - presumably so relatively unsophisticated IT guys can install it.

Hewlett Packard is also getting its growth in blades - but - frankly - not at anything like this rate. Partly they are incumbent - but mostly I think they are just ceding share to a company - that at least on that area has its eyes firmly focussed on the prize. Here - and I quote verbatim - is the quarterly highlights.

Dell’s commercial business continues to benefit from improved demand across all products and services, and in all geographies as Dell expands its enterprise solutions portfolio. Recently, Dell acquired Scalent, developer of virtual infrastructure management technology, and Ocarina Networks, a leading developer of storage optimization technology. The company also announced an agreement to acquire 3PAR, the leading global provider of utility storage for cloud computing. These moves illustrate Dell’s commitment to build its capabilities for open and affordable enterprise solutions.

This has me more-than-passingly surprised. In a world where the beige-box disappears Dell, once the biggest maker of beige-boxes, is finding itself a seat at the table. It may not be as good a seat as they held in 1998 - but it is a seat nonetheless. And they are doing it by going where the puck is going to be. And that has me surprised because - personally - I hate Dell like I hate few other companies. They sold a defective computer, replaced the defective part with another defective part and kept me waiting in endless phone-center loops.

But their agility here had me covering my short last night.

I am - I confess - truly stunned. If you ask me whether Michael Dell should keep his job. On the evidence of this I have no doubt...

John

*blades - for the non-geek - are the most effective way of getting really dense and cheap mondo-computing capacity. Blades sit in boxes which have integrated power supply and cooling and are effectively the ready-built motherboard of a server ready to plug in. You can get an enormous amount of computing capacity into a small room filled with blade servers. [The room will also need serious cooling.]

Sunday, August 15, 2010

Actually my wife is an architect – so I risk marital issues by ripping into the profession for the vacuous waffle-bags they are.

Well sometimes are.

I present to you McNally – an Australian architecture private company which did a commercial fit-out for Absolute Alpha – the funds management company that later renamed itself the Astarra Asset Management and were responsible for the Astarra Strategic Fund. (Regular followers of this blog will know this fund for the disaster that turned out to be…)

This is a high quality commercial fitout for a Funds Management company.

The design came from close study of the organisation’s work methods, practices, technology, culture and vision. High quality finishes are used throughout with colours reflecting the companies [sic] corporate identity. All spaces have connection to the external windows that have panoramic city and harbour views. The end result is improved office efficiencies and productivity. This, along with enhanced staff satisfaction, makes this project a success.

Completed 2007.

Now McNally say that their design came about – and I quote again – “from close study of the organisation’s work methods, practices, technology, culture and vision”.

Ok – here is what the work practices now appear to be: Absolute (or later the Astarra Asset Management) invented the returns for the “strategic fund” (or their Hong Kong controllers invent their returns). They looked good. They had an impressive sales function that paid undisclosed (hidden) commissions to financial planners. When they raised money they wired it to a bank account in either the British Virgin Islands or the Caymans never to be seen again.

The conclusion – either the architecture company is

(a) Vacuous – as they did their “close study” and did not notice the bleatingly obvious truth,

(b) Complicit in the crime – in that their close study did reveal the truth but they chose to ignore it for the commission or

(c) Lying – in that they did not do a close study of the “work methods, practices, technology, culture and vision” but said they did for marketing purposes.

When shown a patina of architect marketing I think of that profession as arty-farty, quasi-psuedo intellectuals who get invited to pretty darn good cocaine snorting parties.

And when an architect says that they get to know their clients I guess it is because they imagine the clients going to those same parties.

Thursday, August 12, 2010

This is not a post with investment conclusions. It is more a little about my own voyage. If you want the stock posts read the last two posts in order.

My purpose

The purpose of this blog (as stated in my profile) is:

to explore investment ideas. [This blog] differs from most investing blogs as I have no intention of talking my own book. However I will explore what is wrong with my investments and that means I need to talk about positives and negatives. I welcome criticism. I most value criticism which demonstrates that some of my ideas are wrong.

Microsoft is (way) outside my usual beat. I am an accounting geek. I like to read accounts to find out where things have been clipped, where the statements are aggressive, where the bodies are buried.

Microsoft is an unusual company because there are no bodies buried in the accounts. The business is staggeringly profitable – and those profits are entirely visible in cash (and equivalents). Usually I add value (if I manage to add it at all) by understanding how the business makes its money and how that is reflected in their accounts. For me reading Microsoft’s accounts beyond a summary and cash flow statement is pointless.

With a complex financial institution (my usual beat) understanding the accounts can be a difficult job. Schiff’s Insurance Observer still refers to “the blonde with more curves than Conseco’s financial statements”. Microsoft’s statements are as curvy as Bill Gates. This is a fabulous business – arguably the best business in the history of capitalism.

So the question:

The outcome for Microsoft stock will be driven by whether – in ten years – we wake up and find that Microsoft has retained dominance in the way corporations interact with their data and a decent position in the relationship of retail consumers and digital data.

If Microsoft is dominant in that they will be making much more money in a decade because there will be much more information – and more computers - and the cost-per-computer is not outrageous even if the total revenue line is.

If Microsoft loses its dominance then the stock could have another weak decade (notwithstanding the fact that it starts at a low price relative to current cash flow). The stock price is so low relative to indisputable current cash flows that Microsoft would really have to stuff it up from here to make the stock a worse investment than say the current ten year bond. But this is technology and it is subject to rapid change.

In my semi-geeky way I tried to run through the threats to understand them. The threats are obvious: virtualization (and hence the end of the hardware-dependent computer), virtualization (and hence the end of the client-server model Microsoft rode to glory), Linux (and free software generally), the resurgence of the Macintosh platform, and (possibly most importantly and certainly most obviously) the increase in (mostly non-Microsoft) mobile devices (which are increasingly how the young and the affluent consumer relates to music and the internet and to data generally).

So far – with respect to most of those threats – Microsoft has not been victorious – but has left itself a place at the table. Even Zune has a place at the table even if it is up the end...

Microsoft has not had an unambiguous winner in a decade – but then they are so entrenched that even without a winner they remain a strong company. They produced one (very) weak flagship product (Vista). But they have a (very) good product now (Windows 7) – it is however sufficiently late to cede a lot of ground to Apple. Still you could imagine a world with an absolutely brilliant Windows 10 (!) phone which integrates near perfectly with business data (being a thin client for the work computer) but also has a lossless music player, high quality music jacks, integrates with Facebook (or its successor) perfectly – oh – and it is as cool as any future iPhone. It just has not happened yet – but a super-hot product would add 100 billion to the cumulative cash flow Microsoft might produce and make the stock a fabulous investment.

On virtualization the “clients” in my experience are mostly windows (or often virtualized windows servers sitting on linux boxes). Microsoft has a position. But the virtualization platforms are Citrix, VMWare and others. The underlying operating system is linux. Indeed Wikipedia gives a huge list of programs and Windows is by no means dominant. Linux (outside the server market) remains a product for geeks and Baltic grandmothers (but is getting better rapidly). Apple look like the winner in mobile devices – but it is early in that game still and I think Linux in its Android form is likely to wind up the winner just because Apple extracts too much margin and the Android product is likely to be just as good (except for the killer iPod app). That said the Windows 7 phone reviews pretty well. Ten years ago Palm was the likely winner in mobile devices. These things change!

A comment on the comments

The comments were very high quality. Sure I found someone who believed that Linux must run on top of (pirated) Windows XP. He simply could not believe that you could run a computer without Windows. [That level of ignorance is itself interesting because it tells you just how entrenched Microsoft is…] But I also found down-in-the-trenches people who could not imagine that any business could go all thin client. [I observed however that quite sophisticated businesses have gone that way already – and it is far superior to the client-server arrangement for security and disaster recovery – but not only is it superior – it is cheaper.] I found religious open-source zealots but also entirely practical people who thought you could not get fired for buying Microsoft. (I noted that in the server business for many applications you would be fired for buying Microsoft…)

I met open-source geeks who thought that Ubuntu – at its current rate of improvement – would be as user friendly as a Mac within 12 months. That is aggressive. It took me considerable effort to permanently mount the windows-share hard drives on my new computer – enough difficulty that I can be sure Ubuntu is not ready for prime time. But given the improvement between my first linux machine [a Mandriva 2006 release] and the current Ubuntu release I think Ubuntu will be up to it in a few years. That said the Mac is more user friendly than Windows and it has not won the war at corporate level. The better product does not necessarily win because of the advantages of incumbency.

A comment on the stock selection

This a long way outside my circle of competence. I reckon I can read a bank’s financial account as well as anybody – but nothing is added by reading Microsoft’s accounts. So to do this I had to become more geeky than is natural for me. Alas I discovered there is as much debate amongst geeks as there is debate amongst bank analysts and – like bank analysts – they are probably all wrong about most things.

Monday, August 9, 2010

I never realized I had quite so many super-smart and geeky readers. The quality of comments – especially those that came through my inbox – was amazing.

This post attempts a synthesis. That is difficult because many of the super-smart and geeky readers had diametrically opposed views. This was typical:

The bottom line is none of this stuff matters enough to get religious about it. If you want to go through a four week learning curve to use Ubuntu, have it. If you want to use second-rate office software because it's good enough, by all means do that. But if you're preaching for a mass conversion to happen, don't hold your breath waiting. In all likelihood your son will soon want a Windows machine so he can play the same games his friends are playing.

And I have to say he is right. Ubuntu is faster – and it is nicer for some things – but I have such huge capital embedded in Windows (years of use) that I will use Windows for many things. Moreover getting Windows games to play on Ubuntu is (frankly) not worth the chop (even inside “virtual windows” – explanation below). Also my son does have a windows partition – and the only thing he runs on it is Cyberlink Powerdirector 8. Games get run on the Wii (or Playstation) – but a non-linear video editor is essential for him in these days of YouTube. My son communicates with movies…

My purpose was not to learn to use Ubuntu. My purpose was to work out where I stood as a stock analyst. It makes no sense whatsoever to change unless you have very specific needs [the usual need being to maintain servers].

By contrast I was told a story about an elderly (and non-techie) woman in Lithuania who was given a brand new laptop with Windows 7 on it. The first thing she did was wipe the disc and install Ubuntu. Why? Because she was used to it and knew how things worked.

And that is the point: these things have inertia – and the inertia is real. Windows is useful primarily because it is there. In particular:

(a). The easiest system to use is the one you are used to. If you use Windows at work it is likely you will use it at home. I feel uncomfortable on a Mac because I have not used one since I gave away my Mac Plus. [That I guess dates me…] The woman in Lithuania felt uncomfortable with Windows because that is not what she is used to using. The cost of changing (four weeks) is just too high.

(b). The price does not really matter. The OEM cost of Windows is about $50. The laptop lasts three years. There is no way that anyone is going through 4 weeks of hard intellectual work of learning a new system (any new system) for saving of about $17 a year. That is simply a non-starter. This defends market share. I hated going from my Mac to a Windows machine at work – but once I crossed that divide all my future machines were Windows. However the young are back buying Macs and that will weaken the Windows incumbency. There are a few places where Ubuntu has serious share (the Baltic states spring to mind) but that is rare. The proof that price does not really matter is the sudden willingness of people to buy Macs at price points up to $500 higher than current PC offerings. They do this because – well – the Mac is nice…

(c) Lots of software is written already for windows – especially games – but also video drivers etc – that do not run as native on linux. Moreover because the desktop share of linux is so small nobody wants to bother porting their software. You use Windows because everyone else does.

(d). Microsoft had a really useful suite of “developer tools”. This meant that many businesses wrote software for their businesses that works in Windows and does not work elsewhere. This also means that they have a reluctance to change. [By contrast most business software these days is written with web-interfaces. We have written a database for work – and our developer wrote it to work on our linux server – but the interface is our browser…]

Microsoft has not come up with a really good “must have” product in a while. That said – Windows 7 is quite a good system – and even my tech friends who are linux devotees – confess an admiration for the new-found stability. This will drive some sales as sensible people did not move from XP to Vista – but will move from either XP or Vista to Windows 7.

Inertia matters and this bodes well for Microsoft. The tailwind (developing countries) remains strong for some time. Inertia saves the Western business momentum. The cash-flow is robust for at least a few years – and will probably grow. I even purchased some Microsoft stock.

Some thought I was overstating virtualization as a future because it is reliant on very fast connections. There are a few responses to that. Firstly within the enterprise (which is the core Microsoft market) virtualization is a reality now. I know a 50 person financial firm whose computers are really two mondo-powerful servers. The 50 staff all have a “virtual box” with the computing capacity shared on the servers. One server would do the job – but two is for redundancy. There are an exact copy two servers in a remote location about 50 miles away – that is the disaster recovery. This is superior in lots of ways. There are no distributed hard drives which makes data much safer from theft (you cannot walk out with a hard drive). There are no USB keys or other ways to pilfer data in the field. The computers are mobile – someone can log on from anywhere in the world. If they move desk they do not need to move their computer. The disaster recovery is really simple – and is an exact duplication of the work machines. No decentralized data to lose. No problem with mirroring.

This is a sophisticated and superior set up. But it is cheaper than the existing set up – and easier to maintain. That is a winner. What works there will work elsewhere. I mentioned this to a UBS executive and he just said they were miles behind on that. But hey – even UBS will catch up! It will happen in the home too – maybe earlier in countries like Australia (which is rolling out the National Broadband Network) – but it will happen more generally. I have gone personally from opposing the NBN (a costly government project) to being supportive (it will allow us to save huge amounts in IT infrastructure). That said – if it works in Australia it will happen everywhere with sufficient population density. Anywhere that you can deliver high definition TV on demand has more-than-sufficient bandwidth.

Linux as the dominant operating system

So lets get to the big point. I am going to put it in bold because it – at first look is such an outrageous statement – but I think it is inevitable. Within 18 months the world’s biggest selling operating system (that is the one in the largest number of new devices) will be linux. It is not even going to be close. Within three years linux will be utterly dominant – maybe a 70 percent share.

The thing is all that share will not be on laptops or desktops. It probably won’t even be on tablets or pads. It will be on telephone handsets. The handset market is about a billion pieces per year. The computer market maybe a fifth that. The dominant phone operating system will be Android – and Android is just a cut-down linux. Who cares about the front-end of Ubuntu (which is adequate). What we should care about is the front-end of Android – which is a winner.

That has implications – and if you were a PC maker or a Microsoft investor you better think them through. But I will outline a couple.

(a). You can run a windows machine or even a Mac on a linux machine using virtualization. This makes possible Windows as an app – or for that matter Mac as an app. This will require more computing power than a handset currently has (but give it time). It will also require some form of “docking stand” into which you plug your keyboard, mouse, printer, very fast internet connection, sound system and maybe a hard drive for mass storage.

(b). Virtual machines can be spread across multiple platforms and can share computing capacity with the platform. So you can have your “windows as an app” which uses the handset for simple tasks (such as word processing etc) and uses the cloud’s processing power for complex tasks (such as rendering an MPEG4 movie for YouTube).

This machine can be far better than the computers of today. Here are a few drivers:

1. Software only from repositories. One of the reasons why Linux has far fewer glitches than Windows is the software loading process. With windows I go to a site and download a .exe file and click (although there are even drive-by infections on the web). Nobody polices the sites I get software from. With Linux most software comes from “repositories” where the software is downloaded from vast servers. (Downloading software from outside repositories is surprisingly difficult…) When the software comes from “trusted sources” it is far less likely to contain a virus or trojan. The Apps store is just a repository – and refusing to allow software purchases outside the store is a protection mechanism. When we do cloud-software the service provider will probably also provide repositories. Cloud computing increases security – and the absence of trojans will increase privacy.

2. Machines are mirrored in the cloud. If you lose your phone you buy another one. You then download your old computer from the cloud. No data is lost. The new “owner” of your phone will not have access to your machine without some serious identification – probably your thumbprint and a password.

So here is the question: can Microsoft – or even Apple – win the “pc as an app” war? Is incumbency enough protection? In the corporate area it clearly is enough for now. The financial firm I described above is fully virtualized. The servers run linux – but the (thin) clients are all Windows.

I learnt a bundle from the comments – so more requested.

Thanks.

John

PS. I mentioned that the virtualized PC does not play games well. There is a reason – I run a laptop. To play the game well the virtual computer would need to take direct control of my graphics card. If it does that the host computer (ie the linux box) loses control of it – and hence loses its screen images. So I can’t play even simple 3d games in my virtual computer. Every business function is fine – but the “fun-stuff” is not. The graphics card companies (ATI, Nvidia) can probably solve this by having dual-chip graphics cards or the like. But no matter where I looked I discovered that graphics cards were the biggest problem with my set up.

It is probably good for me to have a work computer that cannot play games. (Saves much time wasting.) But it is not ready for general prime time. Again solutions cannot be far away – but they are not really viable for a non-geek now. [My computer will accept a second graphics card through a PCI slot. This is precisely what is envisaged by the manufacturer when they put that option in the BIOS.]

Friday, August 6, 2010

Forgive a long post – but I suspect this might develop into a theme. My business partner thought I should break this post up – but I figured I should put the outline in one place and refer back to it. There may be follow ups but this stands on its own.

My original motivation for this examination was Whitney Tilson's rather convincing looking buy case for Microsoft. Microsoft is – by all conventional measures – pretty darn cheap these days. Whitney Tilson (a well known hedge fund manager) details how cheap and he does so without mentioning what I think is the most important driver.

The driver that I think Whitney was not mentioning – and which I have not quantified – is the shift of much of the world to laptops. In America or Australia if I buy a desktop PC it almost invariably comes pre-loaded with Microsoft. It is however a surprisingly easy thing to do to build your own PC – buying the components separately to get precisely the PC you want. I have done it and works. The reason this is possible is that standards have made the PC modular – all the plugs and protocols are common. Nobody other than serious geeks (or gamers wanting to soup things up) does that in West – but in developing countries it is not uncommon for your local computer supplier to do it. After all – if you put a computer together yourself you do not pay anything to Microsoft – and you can – if you want – you can install a pirated computer system. By contrast. if you go to a computer shop in Mumbai there is a fair chance that the machines are “white label” and the system is “not genuine”. However there is almost nowhere in the world you can buy a (retail) laptop (other than an Apple laptop) which does not come pre-loaded with Microsoft. You used to be able to buy “bare bones” laptops in Australia – where you added your own memory and CPU to your own specs – but I can't find them anywhere.

As the world (particularly the newer markets in India and China) moves to laptops the “not genuine” problem for Microsoft evaporates. Growth in laptops in India is nirvana for Microsoft.

And Microsoft is so cheap that any increase in sales will make the stock look extraordinary. The stock at this point does not need many drivers.

The negatives are the re-emergence of Apple as the “must have” product – especially for the young and affluent and the encroaching of linux – which is now dominant in servers – as well as entering the retail market through things like the $250 net-book computer and through being the basis for some mass market products (ranging from Android phones to PVRs).

I wanted to explore the negatives (especially linux and virtualization) properly and so I spent a couple of weeks turning myself into a geek. This post explores that journey.

If you are a “real geek” and you know what you are doing you are probably going to find all of this shockingly naïve – but I still want your comments because that is how I learn. If however you are like me and pondering the stock maybe I will save you some work.

I will start with a conclusion which should not surprise any geek – but tends to surprise non-geeks: linux is the “real deal” and is a much bigger threat to Microsoft than Apple. However it will also change Apple's (laptop) business model beyond all recognition – and it will do so via virtualization. It will also change the hardware business beyond recognition. Indeed it is already doing so.

I have now changed my laptop to a linux (Ubuntu) machine and run a piece of software (Virtual Box) on it. Virtual Box is a program which pretends it is another computer – a virtual computer. On virtual box I run Windows. This is – I believe – a superior set-up and it is unlikely I will ever run a machine primarily on Microsoft again. I will explain why more fully below – but first I just wish to make a simple observation... if I take the hard drive out of my laptop and install it in my old laptop everything works just fine – the whole computer is functional. If I tried to do that with a windows operating system it would fail. This is likely to be important in the future of computing because I will be able to migrate my computer from a laptop to the cloud – or possibly onto my (linux powered) phone. It is unbelievably useful to have a hardware-independent computer.

I warn in advance that I have not come to very strong stock-conclusions. But I have learnt a lot – so this is a post to detail what I have thought along the way – and an invite to have the “true geeks” correct me.

Three business models for an operating system

There are three business models around for operating systems – two of which are closed source (Apple, Microsoft) and one of which is open source (Linux, FreeBSD etc). The first part of this post explains these models and hence explains what software is good for and what it is not and how that derives from the business model.

Historically the most important of these models is Microsoft. Microsoft builds software which they license very broadly. Anybody is allowed to build a computer and run Microsoft on it. Microsoft sells to almost all computer manufacturers. Hardware makers competed to produce better and faster and cheaper computers. All of that competition took computers from a highly niche product in 1984 to a must-have for a very large part of the world. Microsoft split the benefit of all that competition with their customers and became frighteningly profitable – probably the best business in the history of capitalism.

But Microsoft's willingness to work with any hardware makers is also the big weakness in the system. I have a computer assembled from bits found on Ebay and (sometimes literally) from bits at the side of the road – and it runs Microsoft Vista well enough. It is probably different from any other computer in the world – but Microsoft has to make it run. And that is difficult for Microsoft – and the computers are by-their-nature buggy. This is meant to work with that – but conflicts are rife and sometimes computers have errors for unidentifiable reasons. The reasons are unidentifiable because Microsoft does not release their source code and without that nobody (and I mean literally nobody) can actually work out what went wrong in some instances. Microsoft can – but only because an “error report” gets sent back to them and – provided they get around to your problem – which presumably means provided the problem is widespread – they can issue a patch.

And that roughly explains Microsoft's position in the market... it works for everyone – but it does not work particularly well (though Windows 7 is an improvement). Moreover Microsoft allows you to use cheap hardware – and that is a good thing.

Apple deliberately took a different tack and the company almost failed. However that tack has resulted in Apple’s new resurgence. Apple do not license their software – and so – because they built every computer allowed to use Apple software they know precisely “what is in the box”. Because they know “what is in the box” the machines work. After all – they are not building for 100 thousand different configurations – possibly only the thirty or so configurations that they have sold. And they can test the software on each of those configurations and if it works there they know it works. (They also limit multi-tasking on some devices like the iPhone because multitasking with 100 thousand apps will produce combinations that they cannot possibly have tested.) Less configurations means less complexity. And because of that there is less “bloat” in the system which makes it faster (for any given hardware).

But there is a downside with the Apple model – and the downside is that there is less competition between hardware markers. Competition between hardware makers works for Microsoft far better than it works for Apple and it meant that Macs were always over-priced (even allowing for the fat margins that Apple builds into its hardware). To some extent Apple solved this by moving to x386 (ie Wintel standard) chips – and allowing the Microsoft competition to work for them. This made the machines cheaper but also allowed geeks to load Apple software on non-Apple machines (ie making a “hackintosh”).

This model positioned the Macintosh in the market. It was the computer that “worked better” and was not glitchy – but it was a niche product because it was more expensive.

It was on this comparison that Microsoft rolled over Apple and became the dominant and most powerful computer company in the world. Macs – it seemed – were doomed to be the (darn nice) niche product.

When Apple finally moved to x386 chips the difference in production costs became less stark – but they remained – and they remain to this day. Still – the fact that Apples work means that for many uses the total-cost-of-operation for a business running on Macs is lower than a Wintel setup. I know a medical centre that recently changed and considerably cut costs. Further – and this bears observation – computer hardware is now getting sufficiently cheap that the disadvantage of the Apple model (lack of competition in hardware) is becoming less significant.

It is worth understanding how larger businesses (say 200 plus computers) have dealt with the problems of Microsoft. Essentially they have tried to give Wintel platforms the advantages of Apple platforms via standardization...

What they do is rather than have 200 different computers throughout their business they have maybe one, at most three different models in use at any time. These computers are essentially identical and they have – sitting on the IT guys desk – three exact clones. When new software arrives (say for example a Microsoft update) the software is thoroughly tested on the three clone computers to make sure it produces no glitches. If the software (or hardware upgrade for that matter) causes no problems they roll it out across the network with all the computers being changed when staff power them up in the morning. The system works because the IT specialist controls “what is in the box”. By controlling what is in the box (often restricting the right of staff to load their own software) they get Apple levels of reliability but the ability to buy Wintel priced hardware. They do however pay a price on hardware – which is that they often get tied to exact specifications for computers. If their business expands they can either (a) get a new computer specification in or (b) order more computers under the old specification. When they do the latter (which would be most the time) the hardware maker has leverage – and selling old computers to business at old prices can be surprisingly profitable. [After computers should fall in cost by about a percent per week – so selling an old computer at an old price is a massive winner for the vendor... and is an important part of Hewlett Packard’s business.] Big business – through standardization – are – in this view – trying to emulate the advantage of being Apple.

There is a third model out there – which is the truly open-source model. In open-source the source code for the software is public and so – with appropriate expertise anyone can see what is going on in the software. [This is different from both Microsoft and Apple as their proprietary software makes computers running on them into true “black boxes”.] If you know what is going on in the software you should (again with appropriate expertise) be able to make your hardware work with it. If your hardware causes glitches you can fix it (or fix the drivers) because you can see what is going wrong. The hardware makers have both the means and the incentive to make sure it works. With Microsoft and Apple they have the incentive but not the means (they can't see the source code). So Linux is strangely the best of both worlds – there is competition between hardware makers so it uses cheap hardware and uses it well and it is really stable – as stable as Apple.

There is however a downside – which is that frankly – nobody much has an incentive to make the whole thing work for the end retail user – that is – the user interface has generally sucked. The thing now comes with two user interfaces (Gnome and KDE) and nobody has much standardized anything. Moreover the interfaces are run by committees and – by the standards of open-source products – they are bloated. This downside is rapidly been remedied. A couple of years ago I tried using linux on the desktop (using Mandriva and OpenSuse) and frankly it was not much chop. I now use Ubuntu and it is nice (meaning moderately friendly). The remedy however is slow at coming.

This description places Linux in the market too. The description is (a) stable, (b) able to use any hardware and (c) less-attractive and user-friendly around the interface. This makes it perfect for nerds and geeks who like the stability and like being able to run their peculiar hardware setups and don't care that it requires some expertise. The place where linux found its main home was on servers. Servers are computers that run all the time set up by geeks and let run without much attention. They tend to need to work together. They are perfect for linux. Microsoft has slowly and surely been losing the server market to linux. If you need your server to work really reliably with hardware of various ages it is almost certainly running some form of linux (or maybe FreeBSD another open-source alternative). The Googleplex unsurprisingly runs on linux derivatives as does the space station and probably most nuclear reactors. Its a great system but user-friendliness has always been an issue. [I know that the linux geeks will object to that statement – but it is odd having to learn codes like “sudo apt-get install cinlerra” and discovering it does not work…]

One more thing that linux offers is considerable ambivalence about which hardware you use. You can run it on many kinds of computers. If you take your hard drive out of one computer and install it in another computer it will probably work straight away. Both Apple and Microsoft are very hard-ware specific. This willingness to be used on many computers is a massive help for a system administrator because she can update the hardware and it will work. Compare this to when you buy a new laptop and you need to reload everything on your shiny new machine. Hardware portability is anathema for Microsoft because Microsoft sell new software every time someone buys a new machine. I replaced my laptop because well – my Dell machine was a turd – and Microsoft – bless them – extracted over a hundred dollars from me. I was not replacing the system which was adequate – I was replacing the machine which was inadequate. Hardware independence would have been incredibly valuable to me because there would be much less problem with migrating settings and other painful but essential tasks.

Apple is more comfortable with hardware independence because you are always using Apple hardware into which a massive margin is built. Microsoft make their money selling software – Apple by selling hardware at fat margins. You know this because you can buy an Apple operating system for $40 down at the local shop – and it is a better system than Windows. The only problem is (at least according the end user license*) you are obliged to run this on an Apple machine. Microsoft sell licenses for their system for about 8 times this sum.

The ipod, iphone, Ubuntu, virtualization and other business model changes

There have been several large challenges to the outline I described above. These were not all that predictable – or at least if you predicted them you might have made a fortune on Apple stock. I will deal with them in order.

Firstly Apple have found a niche where their product is simply superior. It is consumer products for non-geeks that want to be (a) super reliable and (b) easy to use. The first of these was the iPod. It was a dead-easy to use music player that met an enormous consumer desire. The previous products in the space (portable CD players, Walkmans) were – at least by the standard of an iPod – very inferior.

The thing about a music player or a phone is that it is ultimately not-that-expensive and it is really important that it just works. And so the Apple model is just superior. And you know this – how would you feel about having Windows on a phone? The question answers itself – there is no reason for a buggy thing (or even a thing with a reputation for bugginess) on a product designed for limited functionality and unsuitable for hardware expansion.

The other non-buggy operating system (linux) is also suitable for phones and Google has done it – the so called Android – which is really a dressed-up version of very-small-linux.

The niche here for Apple however is for products that are resistant to hardware expansion and have to just work. iPads, iPhones and others fit. The completely closed software shop is part of the way to get these things to work. If the software shop is completely closed then you know it won't cause glitches because you control (a) the software and (b) what is in the box.

Windows 7 might be modified for a tablet PC but it is likely you will think about Windows on a tablet just like you think about Windows on a phone? Why bother? A linux limited purpose computer makes more sense – and that is what most netbooks are. The $200 netbook comes with an operating system and some basic software (web browser, word processor, spreadsheet etc) – and with little expectation by the customer that they will dramatically expand their use. A super-stable open-source system is just fine. [You do however attract consumers by allowing games and fun-stuff – and the Apple software shops do that better than an open-source platform.]

The second big change is that the front-end of linux is now becoming more user-friendly. Ubuntu is the big driver here. Ubuntu is a distribution of linux originating in southern Africa with an explicit aim of user-friendliness. Also some of the key products (for instance Open Office) have crossed the threshhold where they are as nice and as functional as the Microsoft equivalent. For most people Ubuntu is a superior operating system to Windows. It is less bloated, does all the key functions and is more stable. Ubuntu has made netbooks at $250 possible – it is a fully functional operating system that will work on a cut-down computer and can be distributed without paying the pound-of-flesh to Microsoft.

There are however problems. The first is several bits of key software will not run on Ubuntu/Linux. For most consumer uses the show-stopper is iTunes. Apple produces a version for (inferior) Microsoft but will not port it to linux. My guess is that doing so would seriously undercut their own business because – frankly – linux has the stability advantage of Apple at a fraction of the price. From my perspective the difficult programs are Windows Media Player, Windows live writer and my feed reader. There are several open-source products which will play Windows streams. However when the streams become heavily featured (with interactive slides for instance) the open-source players simply fail. I have learnt to hate companies that do their conference calls using proprietary Microsoft systems. [The biggest offender is Bank of America. Will IR please stop it. Pretty please you slime-bag monopolist lovers...]

Still I can't expect Bank of America IR to stop using Microsoft proprietary systems for their conference calls until there is a critical mass of people who complain or cannot listen – and there will not be a critical mass of people who complain until there are enough people who go open source. We have a critical mass problem. You are forced to continue to use the inferior Windows product because – well – everyone uses it. And everyone else uses it for much the same reason. The $250 net-book is a serious threat to Microsoft because it might over time produce the critical mass of people who use Ubuntu or like systems – and that will enable us all (even those of us with pricey laptops) to switch to Ubuntu. [It is a threat that Microsoft is meeting by allowing cheaper operating systems on super-cheap laptops. You can buy a Window 7 laptop in Aldi in Sydney for the same price as a software license. Obviously Microsoft has discounted somewhere…]

There are also other costs of using Ubuntu. The main one simply being that things are different to what you are used to – and hence difficult. For instance you go to the “start” button in XP to turn it off. Who would have guessed that? But you “know” it instinctively. Likewise you know that there is a “snapshot tool” in Vista – but you do not know that the equivalent in Ubuntu/Gnome is “shutter” and you need to download it as it is not standard with the system. We have many years of human capital invested in Windows – and even though it is “inferior” it takes some weeks to change. It is not a light consideration. Inertia is a powerful thing. (Mind you Microsoft faces its own inertia as it tries to move happy-enough XP customers to superior Windows 7. Inertia cuts both ways.)

I strongly suggest you (dear readers) solve the inertia problem for your family and give your 7-10 year old kids old computers loaded with Ubuntu. Relative to anything else you can give them on an old machine it is mondo-powerful – and they will grow up understanding computers in a way that you simply do not if you are not a geek. Open-source is a superior learning environment. [My son loves Ubuntu...] Any school teacher who runs a primary school computer classroom where the computers are not Ubuntu is – frankly – being lazy.

There is a reason why Ubuntu has suddenly got better though – and that there is a rich individual – and more recently Google is behind it. There is an internal Google operating system (not publicly released) called Goobuntu. Security concerns mean that Google staff are now prohibited from using Windows. More pertinently the new (highly minimalist) Google operating system (the Chrome system) is a cut-down version of Ubuntu. Google intends on using Ubuntu and its derivatives to hammer Microsoft – and – frankly – the faster your children learn to use them the better. [The cost for an individual changing is high – I reckon about 4 weeks of productivity – about what it has cost me... but the cost for a child is zero because they have no human capital built into the alternative system.]

There is a third major change to this operating system business – and that is “virtualization”. Virtualization is the business of running a machine within a machine – or for that matter a machine across several machines pretending it is one machine. For instance when you query Google it seems like you are querying one machine – but in reality the Googleplex is maybe a million machines pretending it is one machine. Similarly one machine can be running six to 100 virtual boxes on it. This will fit many of my readers. If you ran a financial business with say 100 staff with their own machine the way you would set it up is with four (powerful) servers – two in the main office – and two mirrored machines in the remote back-up location. Each staff member would have their own “virtual machine” sitting on the paired servers. They would have allocated RAM, processing capacity and hard drive space but when that is not been used it would be allocated to other staff members. Every virtual machine could be made available off-site (for example if staff members travelled). When staff change their desk their machine (which is virtual) does not need to be moved. More to the point – the machine is entirely hardware independent. If you need more RAM collectively you just add it. The servers would be running some flavor of Linux (probably SUSE or Red Hat), the virtual box would be either open-source (“Virtual Box”) or proprietary (VM Ware) and sitting on the virtual box would be Windows or Ubuntu or – for that matter – Macs. [I will discuss virtual Macs later on...] The computer can be migrated from one server to another dead easily [the “hardware” is the virtualization program]. It can be scaled easily. It can be duplicated easily. Moreover the system can be made generally redundant easily (the Googleplex has much built-in redundancy – if a computer or a thousand computers in the Googleplex goes offline it does not much affect the service). VMWare is arguably the hottest stock in the hottest sector at the moment.

The beauty of hardware independence is that everything can be changed – and by running (extremely stable) linux and (unchanging) virtualization programs you can bring the stability of linux to everything. The virtualization set-up is frankly superior – and it will improve the stability of Microsoft – perhaps eventually to Apple levels.

And that sounds fantastic for Microsoft – but alas it comes with a very big price ticket. Microsoft relies on hardware dependency for sales. The reason I buy a new operating system is that my Dell sucked – not because I really wanted to own Vista (or even Windows 7). I was happy-enough with XP. I had to upgrade simply because – well I had to upgrade my hardware. The motive for buying a new computer is almost never because it runs the latest version of Windows. The motive is that it is a bigger, more powerful computer and my old one can't keep up with my demands (or is defunct as per most Dells). Indeed there is a cost to upgrading. [I hate the new picture-driven menus on Office 2007 – and have reinstalled my old Office 2002 because I am used to it. The upgrade sapped productivity and gave me the incentive to learn Open Office. After all – if I have to learn it all again I should – by rights learn it all again on something that is free and possibly superior...]

Virtualization – and hence hardware independence – will simply mean that Microsoft sells much less. Indeed – I can't see why they need to sell anything at all after they have sold you a virtual seat – you can just upgrade the hardware around your machine and keep the software as pristine as you like. Indeed if the server you use is out there in “the cloud” you will never need anything other than a terminal. Virtualization – and hardware independence – is really scary for the boys from Redmond. [By far the most unconvincing argument in Whitney Tilson’s piece is that Microsoft is a key player in the new trend of virtualization.]

And Microsoft know it too. A while back Microsoft was telling us it wanted to change its model for selling the product to business. Previously they sold it on a one-off license basis. Now they wanted to rent it. And well might they – because with virtualization you might go a very long time between upgrades. They know that consumers (who buy machines rather than seats) would not be interested in that – but maybe they could sucker business along with a lower first-time charge.

Apple and virtualization

This is a harder topic. Apple by-and-large do not sell to “the enterprise” and their computers do not virtualize that easily (primarily because in most countries they will not let you). The Apple End User License Agreement (EULA) makes you agree not to install the software on any non-Apple machine (except in countries where such a restriction is illegal). I think Australia is the most notable “except in” country – which means (I think) I am allowed to install the software on a non-Apple machine. [Third line forcing rules in our antitrust legislation would make it a criminal offence for Apple to enforce their license terms...] Anyway I set up Snow Leopard on Virtual Box – and to tell you the truth – installing it the first time was a first-order pain. However copying it would be easy. [After all – it is virtual and I can copy it very quickly – it is just hardware independent software...] I am going to close it and give my snow-leopard disc as an upgrade to a friend because – frankly – now I run Ubuntu a Mac is simply not that attractive.

Apple don't sell much to “the enterprise” and their model is to sell the software cheap (the system cost me about a tenth of a Microsoft system) and make money on retail sales of hardware. If they can get Apple into big business they win – and they are not savaging their own hardware sales. Apple might get to sell some of their (outrageously expensive) server products to companies that might virtualize. And the given you only need to buy the seat once – and the young customers love their Macs (for good reason) it might actually be the sensible way to run. They might also sell virtual macs through the cloud – at a rental fee.

I suspect however there is another game here. Hardware independence is a truly wonderful thing for mirroring. When I take my Windows hard drive out of my Lenovo and put in the (crappy) Dell it does not work. But my linux disk does. I can set up a mirror for my laptop to a desktop at work (as the same information will work in both places) – so I do not need to cart the laptop with me to and from the office. Given how fast computer processing is getting small and powerful there is a reasonable chance I should be able to clone a whole computer into a mobile phone – and keep it in my pocket – but have it securely running on the desktop as well. Apple could win at this – and I do not want to speculate as to where they are going.

So back to Tilson’s argument

Microsoft clearly is really cheap. And there is a huge driver he has not even talked about – the shift of (say) India from white-label desktops to “genuine Microsoft” laptops. But I suspect the whole business is more vulnerable to a complete paradigm shift (virtualization, cloud etc) than I would like. There is a chance Microsoft’s business just collapses – and with it the hardware business. Hardware independence really is the big deal and whilst I might consider the stock I would not label the holding permanent. The boys from Redmond should be scared because they rode the wave of distributed desktops and laptops to glory and that wave looks a little stale now.

John

PS. In doing this someone suggested to me that if you play a Microsoft Midori (their future virtual offering) disk backwards it asks you to pay homage to the Great Satan. He however suggested it was far more dangerous to play it forward. In that case it might actually install Microsoft Midori.

PPS. Whitney… if you have made it to the end of this then I am saying hello.

Wednesday, August 4, 2010

I do not do links often – so they have to be good. These two are gems and I am (a) sick in bed and (b) working on a very long post on a new topic which may not be posted as I am not sure I understand it…

The first link is to Jim the Realtor who has been doing some down-in-the-weeds looking at shadow inventory in San Diego. His conclusion is non-consensus – the problem is massively overstated:

His observation accords with the conference calls of many banks. Southern California is – if you believe the bank spin – and you now have reason to – better than most commentators think.

Florida remains worse – possibly much worse. (Alas I have a small bet on a regional bank in Florida that is not quite working out…)

The response to Jim the Realtor is to argue that the true “shadow inventory” is in property not yet foreclosed on. Alas in Southern California it seems the delinquent inventory is falling too. (Again Florida looks worse…)

The second link is a detailed reading of the Valukas report into Lehman’s failure. The “Economics of Contempt blog” (which I should put on my blog-roll) goes through the ways in which Lehman faked its liquidity. [I was short Lehman at various times and it never even occurred to me that they were faking their cash balance…] This does not go to the core issue of solvency – but it does speak to the culture (and possibly to criminality).

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.